Publisher’s Note: The Port Phillip Publishing offices are closed today in remembrance of Anzac Day. Your regular Bill Bonner essay will return tomorrow.
You’ve probably heard of Warren Buffett’s investment strategy already. He buys great businesses at fair prices.
If you dig deeper, Buffett looks for a competitive advantage, great management, high returns on capital and a depressed share price.
But ‘Buffett’s way’ isn’t the only way when it comes to beating the market. Buying ugly, undervalued companies can also beat the market.
It’s how billionaire Carl Icahn made a fortune.
If you’re not familiar with Icahn, he is a true value investor. That means he only buys companies for less than he believes they’re worth. But instead of buying well-performing companies at a fair price, often, he’ll do the opposite…buying struggling businesses on the cheap.
By building up large holdings, Icahn puts pressure on management to unlock value. This value could take the form of selling off poor-performing assets, or selling the entire company. Few practice this activist style of investing. But it’s a strategy that has skyrocketed Icahn’s wealth.
The US has few undervalued activist targets still standing. And it’s because US stocks are yet to come down from their high valuations.
It’s why some activist investors are now eyeing Aussie companies. One of Australia’s most iconic businesses, BHP Billiton Ltd [ASX:BHP], is in their crosshairs.
Giving value back to shareholders
You will rarely see management wind down a company. Even if the business makes loss after loss with no future prospects, it continues to operate. Why? Management often thinks more about their employees, not to mention their own employment, than shareholder value. And instead of returning capital to shareholders, they end up running the business into the ground.
This is why we need activist investors to help sort (that, is sell off) the bad apples before it spoils the whole bunch for the company. I’ll give you an example.
In 1974, the Tappan Stove Company trended down with the market. It was one of many poor-performing stocks that year. But when it reported its first loss in 40 years, the stock fell off a cliff.
Management had made a disastrous move into a new market. In 1977, Icahn started to follow the distressed company. The stock was trading for $7.50 per share. But Icahn believed the company had a book value of around $20 per share.
By 1979, Icahn had built up a sizeable holding in Tappan. He told the company president, Dick Tappan, he was interested in the company as a takeover target. He even tried to set up meetings with Tappan and potential buyers.
Icahn’s motives were probably self-motivated. But it would be better to sell off the company now, than to watch its share price nosedive.
But Tappan wasn’t open to a takeover. This led Icahn to take matters into his own hands. He wrote shareholders a letter:
‘During the past five years Tappan, under its current management, has lost $3.3 million on sales of $.3 billion and during the same period [Dick] Tappan and [Donald] Blasius, Tappan’s Chairman of the Board and President, respectively, received salaries and bonuses totalling $1,213,710.
‘If I personally owned a business with these operating results and which had a substantial net worth, I would certainly seek to sell that business. I believe the same logic should apply in the case of Tappan.’
Icahn quickly won a seat on the board and went to work. He unlocked value by selling Tappan’s assets. All the while, Icahn looked for potential buyers.
It wasn’t long before Swedish appliance maker Electrolux AB [STO:ELUX] emerged. ELUX bid $18 per share for the company. It represented a $2.7 million profit for Icahn and a 90% return on his investment.
But it wasn’t just a win for Icahn. Tappan’s shareholders were also better off.
BHP now finds itself in a similar situation. Hedge fund Elliott Management is pressuring management to make changes. Changes which could unlock value for shareholders.
Unlocking value in BHP
Reported by the AFR:
‘Elliott is pressuring BHP to unify its dual Britain-Australia listing, sell US petroleum assets and return billions of dollars in capital to shareholders instead of investing in mineral and energy projects.’
According to BHP, Elliott’s proposals are ‘not new’:
‘We have assessed in detail many times over the past years options to unify the DLC structure and enhancements to our portfolio, including divestment of Petroleum. Consistent with our capital allocation framework, we regularly consider buybacks as an alternative use for our excess cash.’
But why, then, has BHP underperformed compared to its peers? As stated by the AFR:
‘Elliott’s 39-page “shareholder value unlock plan” purports to show that BHP has financially underperformed a comparable portfolio of competitors including Rio Tinto and basket of oil companies since the South32 demerger, over three years, over five years and after BHP withdrew its bid for Rio in November 2008.’
Critics of activism believe Elliott could be doing more harm than good. But just one letter from Elliott will encourage BHP to think more about shareholders’ interests.
This is why we need activist investors. Great management is not always easy to come by.
Management should always think of how they can improve value for shareholders. Regardless of Elliott’s motives, I view what they’re doing as a positive. They’re reaffirming to BHP’s management what they’re there to do — run a profitable business and increase shareholder value.
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